It is commonly said that…the Fed needs to tighten to fight inflation, which will make things good again once it gets inflation under control. I believe this is both naïve and inconsistent with how the economic machine works. [Here’s why.]
This version of the original article by Ray Dalio has been edited [ ] and abridged (…) to provide you with a faster and easier read. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.
…The facts are that prices rise when:
- the amount of spending increases by more than the quantities of goods and services sold increase,
- the central banks take money and credit away from people and companies to reduce their spending and
- when central banks raise interest rates, which
- increases the amount of money that has to go toward paying interest,
- decreases the amount of money that goes toward spending and
- lowers spending because it lowers the value of investment assets because of the “present value effect” which further lowers buying power.
My main point is that while tightening reduces inflation because it results in people spending less, it doesn’t make things better because it takes buying power away. It just shifts some of the squeezing of people via inflation to squeezing them via giving them less buying power.
The only way to raise living standards over the long term is to raise productivity and central banks don’t do that so, what do central banks do?
- They move demand around by providing and withdrawing spending power by influencing the creation and amounts of debt assets and debt liabilities. They do that in a way that naturally produces cycles in markets (bull and bear markets) and economies (expansions and recessions).
- More specifically, they inject doses of stimulation into the system via injecting credit and money into the system, which produces increases in demand for goods, services, and investment assets that are followed by periods of paying back and withdrawals of the stimulations, which produce lows in demand that are depressing.
- They typically provide another and even bigger dose of stimulation whenever these depressing periods of paying back become too depressing…[and these] short-term debt cycles (also known as the business cycle) typically last for about seven years give or take a few.
These short-term debt cycles add up to the long-term debt cycles that typically last about 75 years, give or take about 25. Because most everyone wants the ups and not the downs, the stimulations and debts that central banks produce typically add up over time to produce more ups than downs until the debt assets and liabilities get unsustainably large, at which point they have to go down via some mix of:
- inflation (due to money printing to reduce the debt burdens by monetizing them, which is inflationary),
- debt restructuring,
- and paying the debt service in non-depreciated money (which is depressing)…
To do their job well central banks should:
- use their powers to drive the markets and economy like a good driver drives a car—with gentle applications of the gas and brakes to produce steadiness rather than by hitting the gas hard and then hitting the brakes hard, leading to lurches forward and backward and
- keep debt assets and liabilities relatively stable and, most importantly, not allow them to get too large to manage well…
Based on the above measures central banks policies have not been good. More specifically:
- the Fed is moving from printing and buying debt at an annual rate of around $1.5 trillion to selling it at an annual rate of $1.1 trillion, and from sharply lowering interest rates to sharply raising them. For that reason, we experienced the big lurch forward and are now experiencing the big lurch backward and,
- because debt assets and liabilities are now very high, and because government deficits will remain high, it is virtually impossible for the Fed to push interest rates to levels that are high enough to adequately compensate holders of debt assets for inflation without them being too high to support strong debtors, strong markets, and a strong economy…
In summary my main points are that:
- there isn’t anything that the Fed can do to fight inflation without creating economic weakness,
- with debt assets and liabilities as high as they are and projected to increase due to the government deficit, and the Fed also selling government debt, it is likely that private credit growth will have to contract, weakening the economy, and
- over the long run, the Fed will most likely chart a middle course that will take the form of stagflation.